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HG Bonds: Leverage Headwinds Mount For Spreads As Debt Growth Surges

As a record-setting year for corporate supply winds down, participants are increasingly citing leveraging trends as a possible headwind for high-grade corporate credit performance in 2014, a concern apparently validated by the latest round of aggregate data supplied by the Federal Reserve.

“Releveraging should present opportunities from the short side for alpha in developed-market industrial credits,” Barclays recently noted in its global outlook report for 2014. With underlying rates already poised to head higher in a challenge to total-return potential next year, the bank further expects releveraging trends acrosss as nonfinancial corporations, coupled with poor market liquidity, to “put a floor on spreads” within 10 bps of recent high-grade aggregate levels, which are at six-year lows after tightening 25 bps over the last 12 months.

Latest data on the financial accounts of U.S. entities published by the Fed this week (seasonally adjusted) revealed a 9.2% surge in debt growth across the nonfinancial corporate sector in the third quarter, driving the four-quarter average to the same level, or a high dating to the period just ahead of the collapse of Lehman Brothers in the third quarter of 2008 (leading to a rare net contraction in debt levels over the next 18 months).

U.S. businesses raised more than $3.2 trillion across all credit markets over the 12 months through September, the most since inking a record-high $3.4 billion of new debt instruments at the height of the housing bubble in 2007, Fed data show. Even after accounting for $1.5 trillion in negative net new equity issuance over the last four quarters amid aggressive share-repurchase activity, businesses raised a net $1.76 trillion on the financial markets over the last 12 months, up from just $142 billion over the same period two years ago and marking a record high for Fed records dating to 1987.

Rising profitability continues to provide cover for leveraging policies, but investors may be increasingly looking askance at diverging rates of growth in terms of leverage and earnings. While pretax profits for U.S. nonfinancial businesses continued 4.4% higher year to year in the third quarter to a new all-time record ($1.35 trillion, annualized), growth over the first three quarters of 2013 (3.2%) was a far cry from the 26% average over the four 2012 periods.

Despite the slower rate of profit growth, companies raised annualized dividend payouts in the third quarter by an outsized 24% from the same period last year, while also paying 5.2% more in capital expenditures. Net dividends amounted to more than 42% of pretax profits last quarter, or four percentage points more than the average over the last four years of modest economic recovery.

Indeed, M&A and share repurchases are key drivers of issuance in December, as all seven nonfinancial debt offerings this week supported shareholder-friendly fiscal policies (Bank of Nova Scotia, Discover Bank, John Deere Capital, and MassMutualalso inked deals this week to bolster general funds).

Devon Energy on Wednesday placed the week’s largest offering – $2.25 billion across four tranches – to facilitate a $6 billion acquisition of properties in the Eagle Ford Shale play from GeoSouthern Energy, while Arch Capital, Crane Co., CubeSmart, and Rockwell Collins issued deals Tuesday and Wednesday backing acquisitions

Cameron International, another oil-and-gas-sector borrower supporting aggressive financial policy, this week placed a $750 million “no grow” offering, backing its recently expanded share-repurchase program. Time Warner – which spent considerably more on share repurchases and dividends than it generated in operating cash flow over the last 12 months amid steadily expanding EBITDA – printed a $1 billion deal to mark its first offering in 18 months.

Year-end considerations weighed on primary-market activity this week, limiting issuance to just above $10 billion Monday-Thursday, down from $25 billion last week and a trailing four-week average near $22 billion, under LCD criteria.

But the spread backdrop remains supportive for would-be issuers ahead of the New Year: despite higher volatility and weaker equities this week, the T+122 level for the Barclays high-grade index this week was three basis points tighter net of December and 25 bps tighter year to year, leaving the latest level at a new low dating to the housing-bubble days of summer 2007. – John Atkins

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